A long-standing criticism leveled against the IMF is that it applies a one-size-fits-all approach to countries in crisis. And, its critics say, the IMF’s fiscal policy advice tends to be biased in favor of tightening. Does the IMF really offer the same policy prescriptions to all countries hit by a financial crisis? In addressing these questions, Sanjeev Gupta referred to work done by the Fiscal Affairs Department over the past several months, in which emerging market countries and low-income countries are considered separately because they face different circumstances and options.
IMF tailors fiscal policy advice
Explaining the rationale for the IMF’s policy advice to emerging market countries, Gupta made five points.
Fiscal imbalances have been a feature of many countries affected by crisis. Most countries that suffered a financial crisis in the second half of the 1990s had large fiscal imbalances and high public debts prior to the crisis, ranging from 30 percent of GDP in Korea in 1998 to 118 percent in Ecuador in 1999. A country’s ability to service its debt, Gupta observed, is a function of its revenue-to-GDP ratio. In the crisis-affected countries, these ratios ranged from 13 percent in Bulgaria in 1996 to about 16 percent in Indonesia in 1998. Failure to address those fiscal imbalances led to defaults in Russia in 1998, Ecuador in 1999, and Argentina in 2001. In contrast, he said, several countries—Mexico in 1995, Bulgaria in 1996-97, and Turkey in 2001—implemented fiscal reforms and thereby avoided debt restructuring. Fiscal adjustment is unavoidable, Gupta emphasized, when fiscal imbalances and insolvency are the cause of the crisis.
Fiscal stress can also be the result of a crisis.An imbalance can arise because of the impact of recession on government revenues: as output falls, a government’s revenues decline, while expenditures on social safety nets may increase. In this case, Gupta said, adjustment may be required to correct the imbalance. Other negative consequences of a crisis—the impact of devaluations on the debt service and the cost of restructuring of banks and enterprises—add to the need for fiscal adjustment.
Negative effects of fiscal reform on growth may be overstated. Clearly, the initial impact of fiscal tightening on economic activity is likely to be negative. But often output declines before fiscal tightening takes place, and, in addition, lower interest rates, reduced sovereign spreads, and improved market ratings offset the initial negative effect of fiscal tightening.
IMF-supported programs have been flexible in setting fiscal targets.In Argentina (1995 and 2000), Korea (1998), and Thailand (1998), IMF-supported programs accommodated larger deficits because of the recessions. And, in 2001 in Brazil, the IMF-supported program targeted a lower primary surplus to accommodate higher investment.
IMF is mindful of the quality of adjustment. Because of a country’s political and administrative constraints and the need to act quickly, Gupta said, some IMF-supported programs have contained dis-tortionary measures such as export taxes, across-the-board taxes on financial transactions, expenditure cuts, and one-off measures including tax amnesties. Still, he said, the IMF has paid increasing attention to the social and distributional dimensions of fiscal adjustment despite the difficulty of identifying and targeting the poor. This can be seen, for example, in Brazil in 1998 and Turkey in 2001, where social spending has largely been protected, and in Asia, where social safety nets were strengthened following the crises in that region.
Larger fiscal deficits in low-income countries support poverty reduction
(budget balance; percent of GDP)1
Citation: 32, 9; 10.5089/9781451932539.023.A005
Data: Sanjeev Gupta and Benedict J. Clements, 2002, Is the PRGF Living Up to Expectations? Occasional Paper No. 216 (Washington: International Monetary Fund)
1External grants are excluded
In low-income countries, Gupta focused on two criticisms: that the fiscal adjustment involved in IMF-supported programs slows progress in reducing poverty and that the IMF limits public expenditures that could be financed by foreign aid. Low-income countries, he said, receive assistance through the IMF’s concessional lending window—the Poverty Reduction and Growth Facility—which allows expenditures and deficits to rise while paying attention to the programs’ macroeconomic consequences.
A comparison of economic performance in low-income countries before and after the establishment of the Poverty Reduction and Growth Facility in 1999 supports these contentions (see chart). Gupta noted, for example, that the average fiscal deficit targets for three years were quite high in Mozambique (15.4 percent of GDP), Zambia (13.1 percent of GDP), and Uganda (9.4 percent of GDP). He also pointed out that expenditures in these countries were higher by about 1 percent of GDP, on average, in the first year of program implementation, including pro-poor spending in relation to both GDP and the share of total spending. This spending was supported by higher external flows. But he acknowledged that the IMF needed to increase its efforts to shield the poor from the potential adverse effects of fiscal adjustment. Overall, he concluded, the IMF does tailor its fiscal policy advice to country circumstances.
Is fiscal tightening the best solution?
Commenting on the criticism that the IMF appears to ignore Keynes’ prescription for fiscal stimulus in a recession, William Cline said that it missed the point of today’s capital market dynamics and ignored decades of political economic history, particularly in Latin America. Most emerging market economies faced financial crisis, he observed, because capital flows to them dried up. It should therefore come as no surprise, he said, that Keynesian fiscal deficit spending was not necessarily the best remedy for those countries. Increasing the fiscal deficit when capital market confidence is low could actually cause economic contraction, Cline noted, because a wider fiscal deficit signals to investors a country’s inability to repay its debt, thereby boosting interest rates further in a vicious spiral. This point, he said, combined with, among other things, the presence of crowding out and a lack of available financing, casts doubt on the effectiveness of increasing the fiscal deficit as a response to a recession caused by a collapse in capital market confidence.
Turning to specifics in IMF program countries, Cline noted there might be some validity to the criticisms of IMF fiscal policy advice in East Asia, where the countries did not have fiscal problems, their ratios of debt to GDP were relatively low, and their fiscal balances were in slight surplus. In Korea, for example, when the markets learned that reserves had declined to $6 billion and short-term external debt was about $100 million, foreign creditors cut lending to Korean banks and corporations, even though government finances were in order. A large IMF loan and the rollover of short-term bank claims eased the liquidity shortage, and positive economic growth resumed. In countries where fiscal adjustments did take place, they were limited to 1 -2 percent of GDP, considerably smaller than the Latin American adjustments of the 1980s. As it became clear that the recessions in East Asia were deeper than anticipated, Cline observed, the IMF revised its programs to allow for larger deficits.
But other countries did experience a fiscal crisis, he said, especially Russia in 1998, Ecuador in 1999, Turkey in 2000-2001, and, to a lesser degree, Brazil in 1999 and Mexico in 1995. He referred to Gupta’s evidence of the relationship between the change in the primary surplus and GDP growth: the deterioration of fiscal performance occurs the year before the crisis erupts—that is, before the output collapse. The normal, so-called procyclical fiscal relationships, which derive from the fact that revenue is more sensitive to GDP than spending is, would have predicted the largest deterioration in fiscal balances in the year of the recession. That, Cline said, supports Gupta’s proposition that fiscal adjustment can have a positive effect.
Cline closed with a few thoughts on Argentina, whose recent crisis also featured a fiscal problem. Basically, he said, “there should have been a larger surplus in the years of strong growth to hedge against the subsequent recession.” A “weak political fabric” was also a problem, making a larger noninterest surplus even more crucial for maintaining confidence and, hence, fiscal sustainability.
Quick reform mitigates social costs
Carol Graham, who has extensively studied the social costs of crises and different policies, asserted that social costs were more often than not wrongly attributed to the fiscal adjustments made necessary by bad policies rather than to the bad policies that triggered the crisis. “Blaming the IMF for the social costs of fiscal crises,” she said, “is like blaming the firemen for the fire.”
Graham focused on the political economy issues associated with short-term safety nets during crises and on the challenges involved in formulating more permanent arrangements, which she said were critical for addressing social costs and preparing for future crises and fiscal adjustments. Given the integrated global economy, future financial market crises appear inevitable, she said, and countries that have more permanent mechanisms in place tend to suffer lower social costs during crises.
Two points are important to bear in mind, Graham noted. First, for most countries, avoiding difficult but necessary reforms leads to worse crises and higher social costs later on. Moreover, timely reform often gives policymakers a framework that makes it easier to identify and protect the poor. Second, many of the reforms entailing implementation of market policies and changes in the balance of involvement in the economy between the private and public sectors have created an environment conducive to the adoption of new approaches to implementing safety nets.
For example, a demand-based approach incorporates participation by beneficiaries and allocates projects or support to the poor on the basis of proposals from local governments and even civil society. As a result, it is much easier to reach the poor and address their priorities. An additional benefit of this approach, Graham noted, is that it increases the political voice of the poor, giving a traditionally marginalized segment of the population a stake in the reform process. This approach to safety nets, introduced during the 1980s and 1990s, has shifted the balance from compensating the more vocal and organized middle-class or public sector groups to protecting the poorest during crises and periods of fiscal adjustment. But, she said, the change may have gone too far. In the emerging market countries, in particular, the near-poor and middle-income sectors are as vulnerable as the poorest people.
Graham observed that the shift had not obviated the need for broader social contracts or social insurance systems based, in part, on progressive taxation and, to the extent possible, on domestic resources, at least in the middle-income developing countries. Ultimately, she said, it is important to move beyond the debate about the effects of adjustment on the poor and to focus on more permanent forms of social insurance for the near-poor as well as the poor.
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